- Production and shipment disruption by the Straits of Hormuz can be offset by capacity elsewhere.
- From production to refining capacity to inventory level, the supply side is on a comfortable plank.
- China’s demand weakness is another strong anchor for a broad range of commodities.
- The renewable energy revolution is decreasing the sensitivity to Middle Eastern fossil fuels.
- Markets will likely adjust in an orderly manner even if matters were to exacerbate substantially.
Intensifying conflict in the Middle East has alarmed the world, with fears of more destruction and expansion of hostilities rising by the day. Markets are rightfully concerned about the impact of a widening war on production and shipment of oil, with Iran accounting for 3% of global oil production (half of which are exported) and the Straits of Hormuz accounting for around a quarter of the world’s oil shipment. Destruction of production and refining facilities in this area would undoubtedly cause a spike in global oil prices. The key questions are how high can oil go, and how badly can it hurt the global economy.
We have seen breathless reports of oil going to $200/barrel before. During the initial months after Russia’s invasion of Ukraine in 2022, concerns about global energy and food supply spiked. But the adverse reaction of global markets should be seen together with how key policy makers reacted.
il jumped by 33% between mid-February and mid-June of 2022, complicating a global inflation picture already undergoing multiple post-pandemic shocks. But the heightened geopolitical uncertainty was countered by heroic supply side responses. From crude oil to LNG, producers in the Middle East and the US ramped production and refining, while grain shipment was facilitated through a wide range of diplomatic efforts. As a result, commodity price volatility eased in the second half of 2022, and has remained contained since then.
Looking at oil production capacity worldwide, we see room for assurance. OPEC+ countries, which have undertaken production cuts in recent years, have around 5.9mn barrels per day (mbd) in excess capacity, about 80% more than the total production capacity of Iran. Outside of OPEC+, production continues to boom in Brazil, Canada, and the US. There is some concern about inventory levels and refinery capacity, but they don’t point to supply squeeze of any major consequence, in our view.
Weak demand from China has been a key dampener for commodity demand during this cycle. Between satiated inventory levels and weakening growth momentum, China’s ytd crude oil imports are trailing last year’s volumes by about 4%. But beyond China’s slowdown, there is a broader, bearish narrative around fossil fuels. As production of green energy is ramped up, there will be, by definition, an easing of demand for conventional energy. The ongoing scaling up of green energy production, transmission, and storage is changing the energy landscape considerably. The world’s need for energy is likely to continue to rise, but the data suggest that they will come increasingly from sustainable sources, capping the global economy’s sensitivity to developments in the Middle East.
There have been substantial disruptions to Middle Eastern oil facilities before, from the 1980s Iraq-Iran war to the 2019 attack on Saudi oil processing facilities. Vulnerability to Middle Eastern oil shipment was much greater then, and still the global economy did not face any major inflationary or recessionary consequences. The current juncture, as argued above, reflects an even greater shock absorption capacity. We hope for hostilities to cease, and will pay close attention to ongoing developments, but our view is that markets will adjust in an orderly manner even if matters were to exacerbate substantially.
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[1] An associate is defined as (i) the spouse, or any minor child (natural or adopted) or minor step-child, of the analyst; (ii) the trustee of a trust of which the analyst, his spouse, minor child (natural or adopted) or minor step-child, is a beneficiary or discretionary object; or (iii) another person accustomed or obliged to act in accordance with the directions or instructions of the analyst.
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